Analysis - U.S. downgrade minor threat next to default prospect

WASHINGTON How much damage the U.S. debt ceiling scuffle does to the United States' reputation in global financial markets boils down to two increasingly plausible but very distinct outcomes: downgrade or default.

The former, while painful, might allow financial markets to hobble through without major incident, though leave the country under a cloud of financial uncertainty that would threaten an already fragile economic recovery.

A mere ratings cut would reflect the judgement of private agencies and could be glossed over by investors given a lack of viable alternatives to the giant $9 trillion (5.48 trillion pounds)-plus market for U.S. government debt. That's the benign scenario.

An outright debt default would be much more unpredictable -- and potentially cataclysmic.

Such an historic event as failure to make payment on Treasury bonds, considered the ultimate safe-haven in banking, would cascade through financial markets and the world economy, dealing a long-term blow to the global standing of the United States.

"Default on the debt would just be a catastrophe, it would be Lehman times ten" said Joseph Gagnon, a former Federal Reserve economist now with the Peterson Institute for International Economics. "Financial markets would seize up. No one would know what is safe anymore."

The U.S. Treasury has warned it will run out of cash to pay the nation's bills on August 2 unless deadlocked lawmakers raise the nation's $14.3 trillion debt ceiling by then.

Another possibility is that the government skirts a debt default by withholding payments to government workers and benefit recipients, buying more time for Congress to raise the statutory borrowing limit.

This scenario, which would still likely lead to a ratings cut, runs a high risk of tipping the economy into recession, but would nevertheless be less calamitous for the global financial system than an outright debt default.

"They are playing with fire and they could well be burnt. No compromise would put us in unknown and dangerous territory, at a very delicate moment for the world economy," said Carlos Vegh, economics professor at the University of Maryland.

With a default, confidence in the United States as an investment destination would be eroded, potentially for many years to come. Countries like China and Japan, the largest foreign holders of U.S. Treasuries, would over time further diversify their portfolios away from dollar assets.

EMERGING AMERICA?

Default would catapult the United States to the top of the list of sovereign states whose political dysfunction supersedes sound economic management -- above countries like Argentina, Ecuador and Russia.

The country's image as a political basket-case is already being cemented.

"U.S. lawmakers are providing a sad spectacle," said Vegh at the University of Maryland. "When you add this ridiculous stalemate over raising the debt ceiling to the less than stellar response to the financial crisis, it confirms the impression that the U.S. is regressing and becoming more like an emerging country."

The risks to the U.S. economy are high enough even without the spectre of a debt default, as a Reuters poll published on Tuesday found.

A majority of the economists surveyed believe the United States will not emerge from the current political stalemate over the debt without a ratings downgrade. More than two out of three said the economy was already being hurt by the scuffle.

Even a downgrade alone would probably push up borrowing costs for U.S. financial firms, putting a crimp on lending.

A failure to make timely debt payments might also trigger credit default swaps contracts, setting off a chain reaction of losses that sends shivers through the world's big banks.

Industrial activity would be hampered, setting in motion another economic slump that could be as severe as the one faced in late 2008, in the wake of the failure of Lehman Brothers and bailouts of insurer AIG and large Wall Street firms.

"To say that the effect from a sharp contraction in obligations to the broader economy would be quite severe might be an understatement," said Michael Cloherty, head of U.S. rates strategy at RBC, in a research note. "Another severe downturn would be just about a done deal."

(Reporting by Pedro Nicolaci da Costa; Editing by Andrew Hay)

U.S. President Barack Obama pauses during a news conference in the Brady Press Briefing Room of the White House in Washington, July 22, 2011.